Fixed Exchange Rate System: Meaning, Merits and Demerits

By Ann Roberts On Feb 15, 2023

Foreign Exchange refers to the currencies of countries other than the domestic currency of a given country. In simple terms, it is the aggregation of the Foreign currencies held by the country’s government, and Securities and bonds issued by foreign companies and governments. The rate at which one currency is exchanged for another is called the Foreign Exchange Rate or Foreign Rate of Exchange. It is the price paid in domestic currency for buying a unit in foreign currency. For example, if 60 rupees are to be paid to get one dollar, then the exchange rate, in that case, is $ 1: ₹ 60. Different countries have different methods of determining their currency’s exchange rate. It can be a Fixed Exchange Rate, Floating Exchange Rate or Managed Floating Exchange Rate.

Fixed Exchange Rate

Under this system, the exchange rate for the currency is fixed by the government. Thus, the government is responsible to maintain the stability of the exchange rate. Each country maintains the value of its currency in terms of some ‘external standard’ like gold, silver, another precious metal, or another country’s currency.

The main purpose of a fixed exchange rate is to maintain stability in the country’s foreign trade and capital flows.
The central bank or government purchases foreign exchange when the rate of foreign currency rises and sells foreign exchange when the rates fall to maintain the stability of the exchange rate.
Thus, the government has to maintain large reserves of foreign currencies to maintain a fixed exchange rate.
When the value of one currency(domestic) is tied to another currency then this process is known as pegging and that’s why the fixed exchange rate system is also referred to as the Pegged Exchange Rate System.
When the value of one currency(domestic) is fixed in terms of another currency or in terms of gold, then it is called the Parity Value of currency.

Methods of Fixed Exchange Rate in Earlier Times

1. Gold Standard System (1870-1914): As per this system, gold was taken as the common unit of parity between the currencies of different countries. Each country defines the value of its currency in terms of gold. Accordingly, the value of one currency is fixed in terms of another country’s currency after considering the gold value of each currency.

For example,

1£(UK Pound)= 5g of gold

1$(US Dollar)= 2g of gold

Then the exchange rate would be £1(UK Pound) = $2.5(US Dollar)

2. Bretton Woods System (1944-1971): The gold standard system was replaced by the Bretton Woods System. This system was adopted to have clarity in the system. Even in the fixed exchange rate, it allowed some adjustments, thus it is called the ‘adjusted peg system of exchange rate’. Under this system:

Countries were required to fix their currency against the US Dollar($).
US Dollar was assigned gold value at a fixed price.
The value of one currency, say £(UK Pound) was pegged in terms of the US Dollar($), which ultimately implies the value of the currency in gold.
Gold was considered an ultimate unit of parity.
International Monetary Fund (IMF) worked as a central institution in controlling this system.

This is the system that was abandoned and replaced by the Flexible Exchange rate in 1977.

Devaluation and Revaluation

Devaluation includes a reduction in the value of the domestic currency in terms of foreign currencies by the government. Under a fixed exchange rate system, the government undertakes devaluation when the exchange rate is increased.

Revaluation refers to an increase in the value of the domestic currency by the government.

Devaluation is different from Depreciation in the following ways:

Basis	Devaluation	Depreciation
Meaning	Devaluation includes reduction in the value of the domestic currency in terms of foreign currencies by the government under a fixed exchange rate system.	Depreciation refers to the decrease in the value of the domestic currency in terms of foreign currencies by the government under a flexible exchange rate system.
Exchange Rate System	Fixed exchange rate system.	Flexible exchange rate system.
Occurrence	It occurs due to the government.	It occurs due to market forces of demand and supply.

Merits of Fixed Exchange Rate System:

It ensures stability in the exchange rate. Thus it helps in promoting foreign trade.
It helps the government to control inflation in the economy.
It stops speculating in the foreign exchange market.
It promotes capital movements in the domestic country as there are no uncertainties about foreign rates.
It helps in preventing capital outflow.

Demerits of Fixed Exchange Rate System:

It requires high reserves of gold. Thus it hinders the movement of capital or foreign exchange.
It may result in the undervaluation or overvaluation of the currency.
It discourages the objective of having free markets.
The country which follows this system may find it difficult to tackle depression or recession.

Fixed Exchange Rate has been discontinued because of many demerits of the system by all leading economies, including India.